Payback period and irr, Financial Management

To look into the feasibility of a new production system, K-Pad, the largest P.C. producer in the region, has spent $88,000 on the technical feasibility study. In view of the favorable comment of the study, K-Pad is considering replacing one of its production system with either of two new production systems - system A or system B. System A is a highly automated, computer-controlled system that uses cutting edge technology; system B is a less expensive system that uses standard technology. To analyze these alternatives, Janice Yan, a financial analyst, prepared estimates of the initial investment and cash inflows associated with each system. These are shown in the following table.

System A

System B

Initial investment

$660,000

$360,000

Year

Cash inflows

1

$128,000

$88,000

2

$182,000

$120,000

3

$166,000

$96,000

4

$168,000

$86,000

5

$450,000

$207,000

Note that Janice plans to analyze both systems over a 5-year period. At the end of that time, the systems would be sold, thus accounting for the large fifth-year cash inflows. Janice believes that the two systems are equally risky and that the acceptance of either of them will not change the firm's overall risk. She therefore decides to apply the firm's 13% cost of capital when analyzing the systems. K-Pad requires all projects to have a maximum payback period of 4.0 years.

Required:

(a) Use the payback period to determine which system should be chosen.

(b) Use both NPV and IRR to rank each system.

(c) Summarize the preferences indicated by the techniques used in parts (a) and (b). Which system should be chosen? Why?

(d) Draw the net present value profiles for both systems on the same set of axes, and discuss any conflict in rankings that may exist between NPV and IRR. Explain any observed conflict in terms of the relative differences in the magnitude and timing of each system's cash flows

(e) Use your findings in parts (a) through (b) to indicate, on both a theoretical basis and a practical basis, which system would be preferred. Explain any difference in recommendations.